How a Hedge Fund Can Use Insider Information Legally

The government is convinced that money managers who consistently beat the market are probably using insider information to produce these abnormal returns. Unfortunately for prosecutors who want to shut this kind of thing down, one way this is done is perfectly legal.

One of the ways for a hedge fund manager to beat the market is to avoid buying stocks ahead of bad news about a company. You can beat the market with a diversified portfolio that avoids buying stocks in companies that underperform.

That's hard to do unless you have a way of figuring out bad news ahead of the rest of the market. Obtaining material, nonpublic information is one way. But if you trade with this information, you risk violating insider trading prohibitions. Hefty fines and jail time won't help you outperform.

So the way to do this is to avoid trading in the companies that are going to announce bad news. Let's say you have a portfolio that regularly buys and sells a diversified portfolio of equities throughout the year. In that case, by obtaining inside information and avoiding buying the stocks with hidden bad news, you would avoid suffering some of the losses that would hit the broader markets.

What makes this legal is that the ban on insider trading applies only to trades. That is, the SEC's Rule 10b-5 prohibits using material nonpublic information "in connection with the purchase or sale of a security." So if you are only using inside information to avoid buying, you are not violating the law.

The trick with this is to avoid the temptation to short the stock. Shorting involves selling the stock—and eventually buying it—which means you're engaging in a prohibited trade.

The other problem is that your quest for insider information containing bad news might occasionally turn up good news. In that case, you'd be stuck having not to buy the stocks that are going to go up. This would tend to push down your returns, of course.

This problem can be resolved by keeping the inside information within silos in a hedge fund. You have various analysts constantly digging for inside information but only delivering "don't buy" notices to the traders. The traders, therefore, would never have the good news that would get in the way of buying a stock.

You could get a bit more complex by also having the analysts deliver "don't short" notices when they have good news. The problem with this is that your traders would then be tempted to interpret this as a "go long" signal. At the very least, this is what the enforcement guys at the SEC would say was happening. So you'd want to confine "don't short" notices to guys who have short-only portfolios.

So are hedge fund managers doing this? Some of the people in hedge funds swear it is happening, although no one I speak to admits to doing it themselves. Perhaps the best guide would be to look for hedge funds that have silo structures that would permit this.